By: Steve Smith
Earnings season has officially kicked off this morning with some of the big banks such as JP Morgan (JPM) and Citibank (C) reporting mostly better than expected numbers. Yet shares are moving lower, which shows trading earnings can be something of a crap shoot.
But there is one predictable pricing behavior savvy option traders use to produce steady profits.
The biggest mistake novices make is purchasing puts or calls outright as a means of a directional “bet.” They are usually disappointed with the results as even if the stock moves in the predicted direction the value of the option can actually decline and result in loss, despite being “right”.
Don’t Get Post Earnings Premium Crushed
The problem is they failed to account for the Post Earnings Premium Crush (PEPC) which I discussed in this article, describing how the implied volatility contracts sharply immediately following the report no matter what the stock does. You’ll often hear traders cite what percentage move options are “pricing in” to the earnings. The quick back of the envelope calculation for gauging the magnitude of the expected move is to add up the at-the-money straddle.
This article does a great job of explaining how to use the straddle to both assess expectations and potentially profit.
Once option traders are armed with this bit of knowledge they advance to using spreads to mitigate the impact of PEPC when looking to make a directional bet. Some will graduate to getting this predictable pricing behavior in their favor by selling premium via strangles or the more sensible limited risk iron condors. But these strategies still carry the risk of trying to predict, if not the direction, than the magnitude of the move.
Here’s a list of the historically most volatile stocks following earnings reports. Which means they are likely to see both the largest increase in implied volatility leading up to earnings, and the largest PEPC.
The Pre-Earnings Trade
The true professionals pursue a safer and more reliable path of positioning in anticipation of the increase in implied volatility that precedes earnings and avoids the actual event all together. Just as PEPC is predictable so is the pumping up of premium leading into the event; it’s just more subtle in that it occurs incrementally over the course of many days.
One strategy for taking advantage of rising IV leading into earnings is a calendar spread, in which you sell an option expiring prior to the earnings, while simultaneously purchasing one expiring after the event. Like any calendar spread it will benefit from the accelerated decay of the nearer dated options sold short. But this has the added tailwind when earnings approach, as the option will see IV rise, causing the value of the spread to increase. To keep the position delta neutral both put and call calendars should be established.
These positions must be established in advance and closed before the actual earnings. The profits might not be as dramatic as catching a huge post earnings move, but they can be substantial. More importantly, they can be consistent and have a high probability.
With weekly options there should be plenty of situations in coming weeks to take advantage of the rise in IV leading into earnings. This site provides a good starting point of a list of names and their options specific pricing tendencies.
With most offering weekly options there should be plenty opportunities for double calendars. As always, do your own research and confirm the reporting dates, but this offers a great starting point.